Reblog: Top 7 Principles of Growth Investing

Investors have many different strategies that they can follow to build wealth in the stock market. Income investors tend to prize dividends above all else. Value investors seek to buy stocks that trade below their intrinsic value. Growth investors, on the other hand, aim to buy businesses that hold the greatest upside potential and tend to de-emphasize traditional valuation metrics that generally show a growth stock to be expensive compared with the company’s current earnings.

Growth investing is highly attractive to many investors because buying the right companies early can lead to life-changing returns. However, companies that promise huge upside potential usually trade at lofty valuations. That amps up the risk that they will fail in spectacular fashion if they don’t meet expectations.

So how can investors increase their odds of buying the next Amazon.com (NASDAQ:AMZN) instead of a Fitbit (NASDAQ: FITB)? While there’s no bullet-proof solution to this conundrum, I’ve found that buying companies with the following traits can greatly increase the odds of success:

• A large and expanding market opportunity
• A durable competitive advantage
• Financial resilience
• Repeat purchase business model
• Strong past price appreciation
• Great corporate culture
• Talented leadership with skin in the game

Let’s dig into each of these principles in detail to see why they work.

1. A large and expanding market opportunity

The greatest growth stocks move their top line higher at a double-digit rate for decades. That’s a nearly impossible feat to pull off unless the company is attacking a massive market opportunity.

A few great recent examples of successful growth companies that are going after large market opportunities include Amazon.com’s aim to disrupt the world of retail and Tesla‘s (NASDAQ: TSLA) foray into the automotive business. Both of these industries literally pull in trillions of dollars in annual worldwide sales. That backdrop provides both companies with a massive runway for future growth.

What’s more, Amazon and Tesla have also succeeded in expanding their addressable market opportunity over time. They’ve each accomplished this by rolling out products or services in new business segments as they’ve grown. For example, Amazon started out as an online retailer, but it now boasts a thriving web services business. Tesla was initially founded to create automotive products, but the company now sells energy storage systems.

A company’s ability to enter adjacent markets is often referred to as “optionality” and is a wonderful trait for growth investors to keep in mind when they considering a potential growth investment.

2. A durable competitive advantage

Warren Buffett is widely believed to be the greatest stock picker of all time, so it makes sense to follow his lead when he speaks about what to look for in great businesses. One of Buffett’s investing tenants is to buy businesses with a  durable competitive advantage, which he lovingly refers to as a company’s “moat.” Simply put, this is a company’s ability to maintain its competitive advantage over its rivals for a long period, thus keeping its profits protected from the forces of capitalism.

Broadly speaking, there are four main types of competitive advantage:

• Network effect: When a new customer joins a network, it creates additional value for all other members of that network. A classic example is eBay(NASDAQ: EBAY). As more buyers joined eBay’s network it created additional demand for goods. Sellers signed on to eBay to meet that growing demand and added even more goods to the network in the process. That attracted even more buyers to the platform. This cycle repeated itself until eBay became a premier destination to buy and sell goods online.
• High switching costs: If it is costly in terms of time or money to switch to a competing product, customers tend to stay loyal even in the face of price increases. A great example of this is in consumer banking. Once a person’s paycheck and bills become linked to their checking account, it becomes a large pain for them to consider switching to another bank, even if the interest rate they earn is lower or their fees are higher. This fact keeps many customers loyal to their banks for years.
• Low-cost producer: If a company enjoys a technological, scale, or geographic advantage that allows it to produce a good service for a lower cost than its competition, it can charge a lower price and still earn good returns. Walmart is the classic example of a company that uses its huge buying power and an ultra-efficient supply chain to sell consumers goods at a much lower price than its competition.
• Intangible assets: This is a catch-all category that includes things like patents, branding, trade secrets, and regulatory protection. A great example of this is Tiffany’s & Co‘s use of its strong brand name to convince consumers to pay a huge premium for its jewellery.

The best growth stocks have at least one competitive advantage working for them that will keep their profits protected from market forces.

3. Financial resilience

The economy is inherently unpredictable, so you can bet that sooner or later every company will face hard times. That’s why it makes sense to strongly favor growth companies that can fund their future growth needs with internally generated profits instead of being dependent on functional financial markets (or as Warren Buffett likes to say, the “kindness of others.”)

That’s why I generally steer clear of growth companies that are operating at a loss or rely on a continual stream of acquisitions to grow. Companies that are operating at a loss will constantly need to tap shareholders for fresh capital in order to keep the doors open. That can lead to high levels of dilution which can mute future returns.

Slow or no-growth businesses that rely on acquisitions to post growth are in a similar situation. Buying other companies outright can be expensive and can often require the acquirer to issue new shares or take on debt to fund the deals. This can also lead to high levels of dilution or a severely weakened balance sheet.

These businesses are ultimately dependent on a factor that is outside of their control (functional capital markets or a high stock price) and might see their growth grind to a halt if the economy was to sputter.

Consider the music-streaming service Pandora Media as a great example. While the company has a great brand name and has grown its revenue quickly for many years, it consistently racks up hundreds of millions of dollars in losses each year. That’s forced the company to dilute shareholders with secondary stock offerings and tap the debt markets for fresh capital. The company’s financial fragility is a big reason why its stock price has been in free fall for many years.

By contrast, growth companies that are already profitable and sport a clean balance sheet are in far more control of their future. In fact, investors can often benefit when these companies face hard times. Specialty semiconductor manufacturer Skyworks Solution saw its share price get cut in half in 2016 after the smartphone market took a breather. However, Skyworks’ debt-free balance sheet and huge profitability allowed it to take action from a position of strength as it ramped up its share buyback program when its share price was trading on the cheap.

4. Repeat purchase business model

Attracting new customers to a business is difficult and expensive. That’s why it is far better for a business to make money by selling products or services to existing customers instead of relying on an endless stream of new customers to drive growth.

This is a big reason why once high-flying growth companies like GoPro and Fitbit ultimately turned into losing investments. These companies each sell electronic products that last for years, which negates the needs for existing customers to make a second purchase. After all, do consumers really need to own multiple sports action cameras or fitness trackers once they already have one?

This simple truth made these companies reliant on pulling in an endless stream of new customers to drive year-over-year growth. While that was possible when these businesses were small, it became an insurmountable challenge once they saturated their initial market niche.

Compare these companies’ business model to a wonderful repeat purchase business like Starbucks. Coffee is purchased and consumed daily (and sometimes multiple times each day), so once a consumer warms up to the Starbucks brand, they tend to buy from the company continuously. This fact makes it much easier for Starbucks to post year-over-year growth as it expands its store empire and wins over new consumers.

5. Strong past price appreciation

For investors who grew up with the phrase “buy low, sell high” drilled into their brain (like me), this can be an exceedingly difficult principle to wrap your head around. After all, why would you seek out companies that have already performed well? Isn’t it a better strategy to buy companies that are down on their luck and are thus “cheap?”

This is a lesson that I’ve had to learn the hard way many times. However, I’ve since changed my tune and I now primarily invest in companies that have already beaten the market.

Why does this principle work? Its because winning companies tend to keep on winning. A stock typically beats the market because its business is humming along and, importantly, Wall Street is rewarding that company’s success with a higher share price.

When I look at my personal portfolio I can see that the best investments I’ve ever made were in companies that had already enjoyed huge share price appreciation. At the same time, some of the worst stocks that I’ve ever purchased were down on their luck and I was able to acquire them at a “cheap” price. The trouble is that in many cases, those “cheap” businesses continued to struggle and my purchases drastically underperformed the market.

That’s why I now vastly prefer to invest in growth stocks that have a history of producing market-beating returns instead of those that have been a sinking stone.

6. A great corporate culture

All growth businesses will need to bring on an endless stream of talented employees over time to enable them to meet the demands of their customers. However, the competition for top talent has become fierce, so it is critically important for a company to be able to retain its key employees for long periods of time and attract high-caliber new ones. That’s why having a great company culture in place is critically important.

So how can investors judge whether or not a business has a thriving culture? While there’s no single answer, I find that reading reviews on the employee review site Glassdoor.com is incredibly useful.

Do employees approve of the CEO? Would they recommend that their friends work there? Do they give the company’s culture high marks? These are all questions that can be easily answered with a few minutes of research.

7. Talented leadership with skin in the game

The final thing I look for in a great growth stock is a CEO who is deeply committed to the company’s mission and is highly incentivized to make the business a success. Often times these leaders are also the founder or co-founder of the business and remain heavily invested in the company’s success. Recent examples of founder-led businesses that went on to drive huge returns for shareholders include Jeff Bezos at Amazon.com, Reed Hastings at Netflix, and Mark Zuckerburg at Facebook.

How can investors learn this information? A few internet searches on the current CEO (or founder if he or she is still involved) can be eye-opening. Where did they go to school? Have they given interviews? How long have they been at the company? Do they sound like they have a passion for the business during their quarterly call with investors or during presentations? Answering these questions can give you a feel for if they are the right person for the job.

In terms of incentives, I always take a look at the company’s inside ownership rate to see if they also have “skin in the game” just like I would if I purchased shares. This means that they own a lot of stock personally and are not just working at the company to earn a pay package.

Does the leadership team hold a meaningful position in the company? Or are they selling stock as quickly as it vests? This information can be easily found by scouring through SEC filings (specifically, you should look for the latest DEF-14A filing as well as recent Form 4s).

The Foolish bottom line

Even if you find a growth company that scores well in all of these categories, you still won’t guarantee yourself a success. However, I’ve been using this checklist to beat the market for several years, and I feel strongly that using these principles will go a long way toward making you a much better stock picker.

The original article is written by Brian Feroldi, appears on The Motley Fool and is available here.